Multinational Transfer Pricing, Tax Arbitrage, and the Arm's Length Principle

This paper studies the multinational firm's choice of transfer prices when the firm uses separate transfer prices for tax and managerial incentive purposes, and when there is penalty for noncompliance with the arm's length principle. The optimal incentive transfer price is shown to be the weighted average of marginal cost and the optimal tax transfer price plus an adjustment by a fraction of the marginal penalty for non-arm's length pricing. Insofar as the tax rates are different in different jurisdictions, the firm optimally trades off the benefits of tax arbitrage against the penalty for non-arm's length pricing. Such a tradeoff leads the optimal tax transfer price to deviate from the arm's length price. In the special, but unlikely, case where the tax rates are the same and the arm's length price is equal to marginal cost, the optimal incentive price is equal to marginal cost